Trust The Process

Includes: O
by: David Van Knapp


Trust the Process has become a catchphrase in sports.

It means sticking to a long-term plan even in the face of bad short-term outcomes.

How does trusting the process apply to investing?

“Trust the Process” is a slogan that has recently come into vogue in the sports world. I believe that it applies in many walks of life, and it is truly significant in investing.

Trust the Process means sticking to a well-grounded methodology to accomplish a long-term goal.

In sports, it is often associated with the NBA Philadelphia 76ers’ rebuilding process. Their general manager, Sam Hinkie, established a long-term approach to bringing a sorry team back to respectability. His process involved down-valuing short-term wins in favor of building a better team over the long term that would bring home many more victories in the future.

Many fans and sportswriters likened that to tanking: Deliberately losing in order to better position the team in upcoming drafts of new players. Hinkie vigorously sold the idea to the Philadelphia fans, asking them for patience with the process. That sounds like a hard sell, but Hinkie pulled it off, getting Sixer fans to embrace it to an astonishing degree.

The same thing is going on right now in Buffalo with the Buffalo Bills. The new coach and general manager are pushing the exact same theme. They call it Respect the Process. They’ve painted it on the stadium walls for the players to see every time they run out the tunnel.

I am a Bills’ fan, and after 17 straight years of missing the playoffs, we are hungry for wins. We don’t want another rebuilding plan, we want to make the playoffs this year.

Nevertheless, after many failed starts with other coaches and general managers, I think the current team is on the right track. They have a grand vision and it is obvious with practically every player they’ve cut or picked up, and others traded for future draft choices, that they are executing the plan.

What Does This Have to Do with Investing?

In investing, I have written often about the importance of having a plan and sticking to it. In a recent article, I offered the following:

Plan, plan, plan. There are many fine models for investing plans. The best of them start with goals, proceed to strategies to achieve the goals, and may include tactics and schemes for executing the strategies. Behind this exhortation to plan is the underlying idea that your investing is just like your own little business. You are the business owner, the CEO, and the CIO (Chief Investment Officer). Run it like a business.

The basic idea is that your plan should start at a high level (vision or goals), then identify the major steps needed to achieve your goals (strategies and tactics), and finally measure outcomes (how well you are doing). Use the feedback from outcomes to circle back and improve your plan over time. It’s a long-term process.

Besides improving your plan through feedback loops, it is a good idea to review your plan once a year or so, as well as any time your circumstances change: marriage, divorce, birth of children or grandchildren, and retirement.

I have had a plan for my Dividend Growth Portfolio for many years. I review it at least annually and change it as I learn more. Here are the section headings from the current version of the plan.

  • Goal
  • Selecting stocks
  • Reinvesting dividends
  • Portfolio characteristics
  • Selling guidelines
  • Strategic reviews
  • Strategies and practices not used

You can see how the headings proceed through the elements of planning. They start with the goal, step through strategies to achieve the goal, and lay out a feedback loop (strategic reviews) for monitoring progress and improving the plan.

Here’s an important point: Your plan is your process. Trust the Process thus becomes, Follow Your Plan. It will guide you through the craft of investing: There is a process for identifying your goals, selecting stocks or other assets to buy, monitoring your assets, deciding what to do with dividends, deciding whether and when to sell or trim positions, and so on.

Trusting the process involves discipline. For example, once you have established the metrics by which you select new stocks, trusting the process means to go where the metrics lead. When you get away from that discipline, your portfolio starts to accumulate junk – lousy assets or assets that don’t help you toward your goals. For most of us, following your plan all but inoculates us from chasing yield or any other glittering object that can derail your long-term success.

Some people think that having a written plan is a total waste of time. Or that rules are made to be broken.

I agree with the latter to a certain extent, especially when you come upon circumstances or opportunities that you never anticipated. That said, I would suggest that if you find yourself departing from your plan very often, that means that you really ought to either stop doing that, or change your plan. Your plan should set out what you actually intend to do.

Many people say that plans should not be too rigid, or exceptions prove the rule. I won't argue those points, but I personally become uncomfortable if I find myself repeatedly making exceptions to the plans that I laid out to reach my goals. Presumably, my plans represent my best thinking when I was not under any sort of pressure.

So my preferred approach, if I find myself in a situation that is not covered by my plan, or where the plan seems to point in the wrong direction, is to think things through again and consider amending the plan. It is not written in stone. You are in charge. You can amend it. You are the CEO.

One big example from my experience is that I decided, over time, to increase the diversification and number of positions in my portfolio. When I began, I held just 10 stocks and would allow a maximum position size of 20%. Over time – greatly influenced by comments I received here on SA – I lowered the maximum position size to 15% and then again to the current 10%. I increased the number of target positions to 20-25.

You will make mistakes. We all do. Learn from them. I prefer changing my plan to constantly making exceptions to it. The plan itself allows for flexible tactics within the overall strategic framework. I keep most day-to-day details out of the plan, because I want it to be strategic and directional rather than a to-do list.

The Difference Between Process And Results

Investing, perhaps as much as any field, has an inherent tension between long-range process and short-term results.

The main reason is that instantaneous results are so readily available. We are bombarded with them constantly, and that makes it difficult to keep your eye on your real long-term goals and strategies.

The unpleasant truth is that following your plan won’t always work – bad outcomes happen to every investor. Trusting the process often means accepting short-term negative results in favor of long-term goals.

Sometimes I see writers evaluating a decision to buy a stock based on the results of the first 3 or 6 months that they own it. Unless you are trading, 3-6 months is far too short to evaluate a decision to buy a stock. If you are investing for a 20-30 year time frame, what happens in the first 90 days is all but irrelevant to your long-term goals.

Trusting the process requires you to endure rough patches. The idea is to take all the best information you can, and then consistently make good decisions based on that information. Usually, the decisions work but sometimes they don't.

While I believe in feedback loops as described earlier, often a short-term bad result will yield no useful long-term learnings. Over time, you will learn to distinguish between true mistakes and “good” decisions that just did not work out. That's how percentages work.

Trusting the process is never over. You continue to build. Let’s return to basketball to illustrate. Let’s say that a player is reworking his jump shot. He works with a shooting expert, and they meet often to go over the player’s shooting technique. The player practices over and over on his own.

The thing is, the player has to continue that process even when the shot is fixed. He never stops shooting the new way, and he must reinforce it by practicing it constantly. Great players like Michael Jordan and Larry Bird never rested solely on their talents. They were famous for their relentless practice habits.

Anyone who has gone through rehab has experienced the same thing. When I tore my rotator cuff a few years ago, I received a cortisone shot and then began rehab. Rehab is slow; it requires trust and a long-term outlook. When you go to a rehab session, you feel worse at the end than before you started. The short-term result is that your shoulder hurts more.

Does that mean that the lesson is to stop rehab? No: You trust that the process is actually building your shoulder back up. Over a long period of time, you can tell that it is getting stronger in everyday situations – even if it still hurts like hell after a rehab session. Rehab continues long after the shoulder has regained strength. I still do the rehab exercises on my own from time to time.

Another great example of the tension between process and results is blackjack. Blackjack is a gambling game that can be played with skill. The skill – known as “basic strategy” – shaves the house advantage to razor-thin margins.

There is no secret to basic strategy. Every gift shop in Las Vegas sells blackjack strategy cards. The casinos don’t care if you use them; some people keep them in view at the table, or the dealer will tell you what “the book” says to do if you ask her.

The casinos don’t mind these cards, because they know that in the long run, they still have an advantage. They are willing to undergo many losses to a player who follows basic strategy. They just want you to keep playing, so that the probabilities, which are tilted in the casino’s favor, have a chance to play out. If you play long enough (absent card-counting), the casino will end up with all your money, and everybody knows that.

Short-term winning streaks for players provide fun. The long-term probabilities in favor of the casinos build hotels.

The casino’s attitude of trusting the process is the same attitude that the player should have. If you do everything mathematically right and still lose, do you draw the lesson that next time you should abandon the strategy? No, of course not. The strategy has been proven. If you lose 6 hands in a row by standing on 19, does that mean you should start hitting to 19? No, because mathematically that would be stupid.

Unlike card games like blackjack, investing does not have mathematical certainty. The best an investor can do is to create a strategy – a process – that embodies the best data, the best reasoning, and the investor’s goals, and then go with it.

What does that mean in practice?

  • Think probabilistically. Do whatever you can to tilt the odds in your favor. Usually this means gathering data and interpreting it intelligently.
  • Don’t get distracted by shiny objects, like a great yield or a seemingly once-in-a-lifetime opportunity that you read about. If it’s outside your standards and circle of competence, someone else’s great opportunity is just a distraction for you. If the stock doesn’t meet your standards, don’t buy it. Feel happy for the people that own it if it works out for them, but don’t let it influence your own methods.
  • Don’t pay much attention to the market’s daily swings. Markets go up and down. Think of the market as simply the store where you go to buy stocks. Just because something is in the store doesn’t mean that you have to buy it.
  • Stick to the aisles of the store where you are competent.
  • Don’t be overly influenced by the opinions of others – about the way you invest, decisions you make, or criticisms of your goals themselves. Certainly try to learn from the comments of others, and be willing to adjust your process if you see a better way.
  • Commit to doing the work necessary to your chosen way of investing. Show up.
  • Use feedback from your own results intelligently.
  • Be patient. If you’re reinvesting dividends, it will take a few years for the compounding effect to reach a significant magnitude. That said, compounding is mathematical, and its effect will take place.

Process In Dividend Growth Investing

Studies show that, on average, investors underperform the very assets that they invest in. How is this possible? They make behavioral mistakes.

The most obvious mistake often is selling to cut losses when a stock (or the market) is falling. The investor therefore does not own the stock when its price is rising. In short, investors (on average) sabotage themselves by selling low and buying high. Selling to cut losses often instead locks in those losses.

Trusting the process speaks directly to behavioral mistakes. There is no doubt in my mind that I became a better investor when I shifted my gaze – my process – from price movement to cash flows, specifically the cash flows that come in the form of dividends.

The reason the shift made me a better investor is that I came to appreciate how the cash flows, by themselves, could help me meet my retirement goals. I redefined my goals in terms of income instead of wealth. That made sense, because in retirement, income is what pays the bills.

For me, it was a true paradigm shift. Falling prices went from being a reason to sell to becoming a possible reason to buy, because valuations were better.

Some might question why an investor focused on cash flow would care about valuation. The answer is twofold:

  • Better valuations when buying make it more likely that there will be fewer instances when steep price declines awaken whatever bad angels I may have in my nature that would start to whisper, “Sell!” They are no guarantee, but they do tilt the odds in your favor.
  • Better valuations mean you get better deals on income. Income costs less.

I switched largely to dividend growth investing in 2008, when the market was crashing. As I was making the transition, I became interested in Realty Income (O), which nowadays has become a famous dividend growth stock. Back then, I felt like I was discovering a hidden gem hiding in plain sight.

I purchased O twice, on April 7 and December 9, 2008.

When I used the phrase above that at better valuations, “income costs less,” that is another way of saying that you are buying at a higher yield. Each dollar you spend translates into more income. Income per dollar invested is the definition of yield.

To illustrate, this is O’s chart from 2008. In addition to price (shown in blue), I have also plotted yield (orange).

You can see clearly how price and yield are inversely related. They are practically mirror images of each other.

When I bought O in April 2008, I paid $26.28 per share, and the yield was about 6.2%. When I made the second purchase in December, I paid $21.83 per share, and the yield was about 7.5%. I bought more income for the same amount of money.

O was an even better value in December than it had been in April. Since my goal was to optimize my cash flow, the second purchase was an even better decision than the first. It was an easier decision because its price had dropped. (The company was still the same company.) That’s one of the reasons valuation matters to me.

The fact that I made either purchase at all was the result of trusting the process of investing for income. The market was crashing, and many investors’ behavior was to flee the market. Mine was to enter it. I owe my ability to do that not to courage, but to the paradigm shift that came with switching my focus from prices to income. Buying at good valuations, and then at even better valuations, made perfect sense. There wasn’t anything scary about it.

That portfolio, which started with less than $50k, now is worth more than $106k. No outside money has ever been added to it. The gains all came from price changes, dividends, and the compounding effect of reinvesting dividends.

Here’s something else that I trust. If the market and my portfolio were to correct 20% or 30%, I will in all likelihood still be receiving the same amount of income from it. That assumes that none of the 21 companies in the portfolio cuts its dividend, which, of course, is not guaranteed. But I am nearly certain that the income from the portfolio will not drop 20% or 30% even if its total value does.

The portfolio is currently generating $3738 per year in income, so its yield is about 3.5%. If the portfolio were to drop 20% in value, it would still be generating $3738 in income. Dividends are not market events. They result from decisions made by companies themselves. Dividends are determined by how many shares you own, not from how much those shares are worth.

What would have changed is the portfolio’s yield, which would become about 4.4%. The price “disaster” would not become an income disaster. Since I hold the assets for their ability to produce cash flow, there would be little behavioral temptation to sell, because the income would still be the same.

One Final Point

It seems that practically everyone feels that a market correction must be just around the corner. It’s been so long.

If and when that happens, Trust Your Process, whatever it may be. We’ve all had several years to think about what to do if the market crashes. If you haven’t really thought about it, do so now and add your best thoughts to your plan.

Each of us invests differently. For some who are traders, planning for a correction will involve selling to take profits. For others, it will involve doing nothing at all, or putting cash back into the market that they have been squirreling away. However you invest, plan what you will do. Don’t let a correction or a crash throw you into uncharted waters that lead to emotional or panicky decisions.

In other words, Keep Calm and Trust the Process.

Disclosure: I am/we are long O.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.